Can Goliaths Be Innovative?

Arpit Gupta, For More Corporate Raiders: (my bold):

There’s welcome news that a hedge fund operator – David Einhorn – has bought up large chunks of Microsoft with the intent of forcing the ouster of the CEO Steve Ballmer, presumably replaced with a CEO more responsive to shareholder interest. The end goal is a more productive use for Microsoft’s capital.

I think this is great news. The key here is that the interests of Microsoft’s CEO and the interests of Microsoft’s shareholders are different; and we as a society ought to sympathize more with the interests of Microsoft’s shareholders.

Basically, Microsoft has been earning monopoly rents based on intellectual property that locks in network advantages. Yet Microsoft’s comparative advantages really extend only to the sort of monopolistic domination embodied in their control of OS and enterprise software….

We don’t want the people who made a lot of money in the ‘90s deciding what to invest in today; in general people and organizations don’t manage to remain at the entrepreneurial frontier all of the time. We want shareholders to take the billions they made from Microsoft and give it to the Microsoft of tomorrow.

Karl Smith made a similar argument earlier in the year about Microsoft, Burning the Corporate Commons:

There is a simple way out of this: shutdown the Online Services Division, double or even triple the dividend and payout the current profits to shareholders….

My sense is that this Burning of the Corporate Commons is a major source of loss in the US economy. In essence Microsoft is captured by its corporate bureaucracy, a group that is more interested in the continued existence of the company than in maximizing profits. The entire point of capitalism is creative destruction, that old firms die as new innovators come along. However, modern firms lock up much of their profits in a war chest designed to keep them from dying. This is pure economic loss. It’s bad for shareholders and its bad for America.

First, the original financial markets no-arbitrage financial engineering conclusion is that dividend policy doesn’t matter (Are there still financial engineers who read this blog? I’ve wandered so far over the years…). Tax issues aside, one can replicate the dividend policy they want just by buying/selling the underlying stock. (I’m not full M-M, as I think capital structure matters a lot.)

But the point stands. Is it true though? Let’s generalize away from Microsoft for this. Is the statement: “We don’t want the people who made a lot of money in the ‘90s deciding what to invest in today; in general people and organizations don’t manage to remain at the entrepreneurial frontier all of the time” actually true?

We shouldn’t necessarily assume so – in the same way that don’t want a talented lawyer to retire after their first big court case because we want fresh blood in the courtroom, it’s not clear that successful incumbent managers wouldn’t continue to innovate. And there’s also something about oligopolies with some market space to breath to take real chances innovating new products. If there’s ground-level knowledge needed, surely that can be contracted out?

Is there a good way to test for some sort of persistence in innovation, returns against R&D, or something? I could be convinced either way, but these arguments are presupposing what needs to be proved.

Here’s Michael Lind arguing that Goliaths are innovative in Democracy magazine:

Far from celebrating small businesses as the laboratories of innovation, Schumpeter argued that a major incentive for private-sector innovation was the prospect that a business could obtain a monopoly or near-monopoly position on the basis of inventions and be assured that a stream of assured profits would repay its investment. Schumpeter believed that in modern industrial capitalism, which he called “trustified capitalism,” the solitary inventor like Alexander Graham Bell or the young Thomas Edison had been replaced by the corporate laboratory like mid-century Bell Labs, which existed only because AT&T was a monopoly. Undercapitalized firms in a competitive market have no money to invest in basic R&D, and the few firms with deep pockets have little incentive to bring about technological breakthroughs that will be shared by their competitors. Schumpeter concluded that the large corporation in an imperfectly competitive market is “the most powerful engine” of economic progress: “In this respect, perfect competition is not only impossible but inferior, and has no title to being set up as a model of ideal efficiency. It is hence a mistake to base the theory of government regulation of industry on the principle that big business should be made to work as the respective industry would work in perfect competition.”

Schumpeter’s argument that firm size drives innovation received powerful support in 2002, when one of America’s leading economists, William Baumol, published The Free-Market Innovation Machine. Baumol rejected the idea that economic progress is driven by the competition of firms to lower prices. Arguing that innovation has replaced price as the critical arena of competition, Baumol argued that most important innovations originate from large, oligopolistic firms, not from individual entrepreneurs or small businesses. According to Baumol, the sharing of technology among firms in imperfectly competitive markets can benefit innovation and economic growth.

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12 Responses to Can Goliaths Be Innovative?

  1. Andrew says:

    There is actually a big literature on the productivity of r&d. 99.99% of the time the “output” measured are patents which is problematic but it is still instructive. I’m not super familiar with studies of contemporary innovation but I just googled up a quick paper which seems like sort of what you are looking for:

    Large Firms in the Production of the World’s Technology: An Important Case of “Non-Globalisation”
    Pari Patel and Keith Pavitt
    Journal of International Business Studies
    Vol. 22, No. 1 (1st Qtr., 1991), pp. 1-21

    http://www.jstor.org/pss/155237

  2. Pingback: Friday links: lack of respect | Abnormal Returns

  3. I agree–there’s no general answer here, just specific analyses of industry sectors and competitive positions on the ground.

    I’ve heard estimates that Microsoft is losing $2 billion a year trying to develop Bing as an alternative to Google in search. If you think that sector should not be a monopoly—who else could make that kind of investment?

    We also have no idea if the money now being “withheld” from shareholders would go to anything more efficient than the entities that are “losing money” at MS because they are cross-subsidized by OS profits. I’ve seen these types of arguments against intra-enterprise cross-subsidization in health law & policy for a long time, and I’m not convinced (see my chapter on specialty hospitals & critical responses to the Bush FTC/DOJ report “A Dose of Competition”). Maybe a MS without bing mainly distibutes the money lost there to a bunch of very wealthy people who now invest in Exxon. That’s supposed to be a social gain?

  4. JW Mason says:

    Seems to me that some familiarity with Alfred Chandler and William Lazonick (not to mention chapter 6 of Dog Henwood’s Wall Street, and the article on Enronitis I linked to a while back) should be the price of entry into this conversation. From where I’m sitting, the transformation of the idea of the firm in the 1980s from a community or social organism with shareholders as just one of various constituencies, to the idea of the firm as simply the agent for its shareholder principals, is at the root of most of what’s gone wrong with American capitalism since then.

    In the current case, the argument is particularly stupid, since it’s just pushing the past-performance-not-guaranteeing-future-results back a step. We don’t want managers of productive enterprises that made a lot of money in the past deciding what to invest in today, but we do want hedge fund managers who made a lot of money in the past (and therefore are in a position to buy big stakes in Microsoft) deciding what to invest in today? How’s that work?

    If capital markets are perfectly efficient, then the same investments will be made whether Microsoft keeps its cash or distributes it to shareholders. And if they aren’t perfectly efficient, there is no a priori reason to think that people who’ve successfully made money in financial markets will do a better job picking investment projects, than people who’ve successfully managed productive enterprises will. The one thing we do know is that hurdle rate for internally-financed projects is substantially lower than for externally-financed ones. So while there’s no good reason to think investment will be better directed if Microsoft is forced to disgorge its cash, we can be reasonably sure there’ll be less of it.

  5. Mike Easterly says:

    Tom Nicholas at Harvard Business School has done some work on this that you might want to read.

  6. pjcamp says:

    “We don’t want the people who made a lot of money in the ‘90s deciding what to invest in today”

    Doesn’t that include Steve Jobs?

  7. Large corporate bureaucracies absolutely have an incentive to perpetuate themselves beyond their useful life as measured by innovation, but only in a world where Groupon is considered an amazing invention would someone say Microsoft is done innovating. Kinect is innovative and the new mobile software, while late, is considered outstanding. More broadly, for every old sclerotic company living on its rents, you can bring up a General Electric (over 100 years of innovation) or a 3M or Motorola (inventor of the cell phone).

  8. Michael Turner says:

    “Baumol rejected the idea that economic progress is driven by the competition of firms to lower prices.” Well, that’s just Schumpeter straight up. IIRC, Schumpeter argued that pure price competition would drive a tendency toward stagnant, low-profit monopolies in almost every industry, resulting in a conglomeration of not very enterprising enterprises, an economic system as static and stultifying as anything you could imagine under socialism. Nevertheless, monopolies can be good for something, even if “monopoly” has become a dirty word. Many large industries are dominated by oligopolies that can plausibly claim they are still competing because they do so much R&D to try to upstage each other. When you look at the incredible web of technology cross-licensing among them, however …. it might as well be the behavior of a monopoly with competing divisions. The oligopoly R&D tends to spray a mist of inventions that are either irrelevant to, or cannibalistic upon, the core business. Allowing smaller players to buy the monopoly position established by those unused “droplet” patents creates a fertile field for further (eventual) Creative Destruction, in other industries, and even in the oligopoly’s own industry. If there’s a problem with applying this innovation dynamic to IT, it’s embodied in something I like to say about the field: just about every real invention in the computer was made before 1980. All else since then is frosting, or a consequence of Moore’s Law finally making some idea practical.

  9. chris says:

    Arguing that innovation has replaced price as the critical arena of competition, Baumol argued that most important innovations originate from large, oligopolistic firms, not from individual entrepreneurs or small businesses.

    Isn’t one of the biggest counterexamples to this point MIcrosoft itself? DOS wasn’t written at Bell Labs or Xerox PARC. (And before you argue that DOS wasn’t all that innovative and only became standard through path lock-in, IIRC the same is true of C and Unix.)

    More generally, the central point of _The Bazaar and the Cathedral_ is precisely that, in software at least, you don’t need a big centralized effort to produce useful innovations. And the bazaars still have a pretty good track record.

    • David says:

      DOS was a success because it was chosen by IBM.

      And Linux and the other flagship open source software projects aren’t really ‘bazaars’.

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